Hedging Bets

Why would anyone trust a hedge fund?

By

June 14, 2007

Hedge funds seem to have been designed as the ideal plutocratic villain for some novel of financial intrigue. These highly secretive investment groups control more than $1 trillion in assets but are so heavily leveraged that their total positions are thought to equal more than $3 trillion. The essence of their business is speculation, which they engage in on the basis of proprietary mathematical models that are guarded more closely than state secrets. The managers rake in obscene sums of money–the highest-paid made $1.7 billion in 2006. And yet they are virtually unregulated by any government.

The Bush Administration sees nothing wrong with this situation. For two years it has stalled efforts by Germany to push the G-8 to monitor hedge funds. The funds, and their private-equity cousins, are controversial in Germany because they’ve been “restructuring” many old-line German companies. Germany’s vice chancellor has referred to the funds as “locusts,” and the Schröder government started investigating ways to make the industry more transparent. Current Chancellor Angela Merkel has continued that effort, and the German finance ministry drew up plans for a code of conduct for G-8 leaders to approve at the June G-8 summit. But even a voluntary code of conduct was too much for the Bush Administration. In the end, the G-8 leaders did little more than agree to remain “vigilant” regarding the systemic risks posed by hedge funds.

The problem is that regulators don’t even collect information about the industry they’re supposed to be vigilant about. Since hedge funds are open only to limited numbers of big investors, they escape all the usual reporting requirements. Even the timid attempt by the Securities and Exchange Commission to impose a registration requirement was struck down by a federal court last summer.

The upshot is that this increasingly significant portion of the capital market–investment volumes have tripled in the past five years–is totally opaque, which recently led former SEC chair William Donaldson to call the hedge fund industry “a ticking time bomb that is going to blow up at some point.” Since major banks and pension funds increasingly invest in hedge funds, the direct effects of this time bomb would extend well beyond the wealthy individuals who are typically thought to be the funds’ main customers.

The hedge funds tell us not to worry. Instead, we should thank them for providing needed liquidity to the financial system. Of course, they do this by being so heavily leveraged, but they claim this is safe because their secret strategies are so flexible and ingenious. Regulation would hamper their ability to engage in these brilliant financial acrobatics, they say.

In fact, it seems that no discussion of hedge funds is ever complete without mentioning how complicated and sophisticated their strategies are, as if complicated things somehow deserve to be free of regulation. It is true that some hedge funds consult with Nobel Prize-winning economists and financial theorists. But the essence of their strategy would have been immediately recognizable to the provincial nail manufacturer in Stendhal’s The Red and the Black, Monsieur de Rênal, whose financial acumen consists of “getting himself paid exactly what he’s owed, while paying what he owes as late as possible.” Rarely has the concept of leverage been more clearly explained. Nobel prizes aside, that’s basically what many of the hedge funds are doing.

It’s a strategy that works great right up to the point when it doesn’t, which is what happened to Long-Term Capital Management (LTCM) in September 1998, when the Russian government defaulted and the hedge fund suddenly had to pay what it owed before it got paid. That led to an almost $4 billion bailout orchestrated by the Federal Reserve amid concerns by US financial officials that world credit markets would, as New York Fed president William McDonough quaintly put it at the time, “possibly cease to function for a period of one or more days and maybe longer.”

The point here is not to engage in populist mockery of people who are in fact extraordinarily brilliant but simply to question the idea that they are morally and intellectually infallible. That’s essentially what you need to believe if you want to categorically oppose hedge fund regulation, as the Bush Administration does.

Former Treasury Secretary Robert Rubin, hardly known for his hostility to capital flows, hints at this point in his memoirs, where he writes that his first reaction to the news of LTCM’s collapse was to say, “I don’t understand how someone like [head of LTCM] John Meriwether…could get into this kind of trouble.” After all, Rubin notes, Meriwether was one of the country’s leading financial minds, and he had two Nobel laureates working with him. But they were “betting the ranch on the basis of mathematical models.”

As with any bet, the only way to be sure you’ll win is to see into the future. Since hedge fund managers, like other human beings, lack this ability, and since it is widely accepted that their business poses a significant risk to the world economy, it is unclear how there can be a good argument against some form of regulation. The issue is not whether hedge funds are inherently good or bad. The issue is that the hedge funds’ best argument boils down to nothing more than two words: Trust us.